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The Investor Safety Net Is Fraying

Since Detroit’s record bankruptcy in July, investors have been more skittish than ever about municipal bonds, once a strong strand in the safety net of boring investments for Americans investors.

Debt issued by Puerto Rico is particularly of concern; large investment houses are busy warning their brokerage sales forces to steer clients away from Puerto Rican debt in an effort to avoid potentially disastrous losses.

Meanwhile, the financial services industry is doing its damndest to block new rules that would make investments in money markets funds safer. Indeed, the new rules requiring money market funds to carry more capital are essential to protecting investors and the industry simply doesn’t want them.

Let’s start with the climate of fear around Puerto Rican muni bonds.

According to the Wall Street Journal last month, the nation’s largest brokerage firms, including household brand names like UBS AG and Wells Fargo, have warned more than 40,000 stock brokers to steer clear of about $70 billion of Puerto Rican debt on the market. Some of Puerto Rico’s bonds are slipping into “junk” territory, as Puerto Rico’s economy has remained weak.

The finances of Puerto Rico right now have an “uncertain nature,” according to one brokerage bond salesman. And the outlook is extremely difficult for the island. “The commonwealth’s three pension funds were, combined, more than 91% unfunded,” according to the Journal report by Kelly Nolan, Corrie Driebusch and Mike Cherney.

Puerto Rico isn’t the only cause for concern, Bloomberg’s James Nash reported last month that California’s largest toll-road agency, is nearing the biggest default in the $3.7 trillion muni bond market since Detroit.

The next fraying strand is money market funds.

Remember, these funds were considered stable and secure before the financial crisis when the first such fund, the Reserve Primary Fund broke the buck and created a firestorm for investors. Chasing yield, the Reserve Primary Fund invested clients’ money in securities backed by Lehman Brothers, which blew up. Once a safe haven, the multi trillion dollar money market fund industry survived a potential run on the bank because Uncle Sam immediately guaranteed other such funds.

Happy to take the support of the federal government at a time of crisis, money market funds have dug in their heels when it comes to honest reform.

“Bank regulators around the world are forcing banks to hold more capital than they did before the financial crisis revealed just how inadequate their capital truly was,” according to Floyd Norris in the New York Times. “But one set of banks appears to be on the verge of keeping the right to have no capital at all.”

“That group is the money market funds, which function as banks but historically have had the best of all regulatory worlds: no capital requirements, no reserves, no fees for deposit insurance and a belief by their customers that they were at least as safe as banks.”

Remember, no investments are ever without risk. Securities are not insured by the government. But before the financial crisis, stable and safe havens existed where mom and pop investors could park money with relatively little risk and get a decent return. Now, it looks like the risk is outpacing the gain in once stable corners of the market such as municipal bonds and money market funds.

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